Wednesday, July 5th, 2017

Lucky Dip

For the last month, our global equity vs all fixed income models have been indicating that an equity correction could occur at any moment. The same is true for our US equities vs US Treasuries model, and most of the BRICS are in trouble against their local government bond markets. The Eurozone and Japan are less threatening, but could be vulnerable. So far, so consensus, but what happens next is not. Most of our clients have been told by most of their brokers that they should “buy the dip”.

We disagree and to the extent that we do agree, we will probably be recommending a different bounce. Because we are dealing with a future correction whose timing, scale and consequences are unknown at the moment, our normal probability-based charts are no good to us, so we shall rely on some simple long term total return charts covering the major equity indices in local currency.

Let us start with the US. It is always possible that we get a 10% correction followed by a strong rally, with significant new all-time highs. But we are late in the profit cycle and big new highs would probably increase the speed at which the FOMC shrank its own balance sheet. If investors think that a significant new high is unlikely after a correction, what is the point of adding to US equity exposure, 10% beneath it? They would have to be very confident of their ability to time the next high and get out before it.

Our first chart compares the total returns of US and Eurozone equities in local currency, over the last three equity cycles. One of the few bullish points for global equities at the moment, is that the top of the last two cycles has been marked by a period of excessive optimism for the Eurozone, which takes the index above the US before it crashes to earth. Euro-euphoria has clearly begun but it may have further to run and may last to the Italian elections scheduled for Q1 2018. If there is a dip in global equities in the near future we would consider using it to buy Eurozone, not US equities, on the basis that the upside is not capped at current levels.

The next two charts show the Emerging Markets in dollars, and Japanese Equities in yen, both vs the US. The problem with Emerging Markets is that they had a huge run from 2003 to 2007, and have done nothing since then. None of our short term charts suggest that EM as a group would react well to a sell-off by US equities. If there is a dip and then a bounce, the returns are unlikely to be attractive on a risk-adjusted basis and there is a real danger of hitting significant long-term resistance just above the current level. By contrast, Japan has just hit a new high for the last three equity cycles, beating the levels set in 2007 and 2015. Of course, it’s not the all-time high, but therein lies the attraction. Most Western investors would regard as fanciful the idea that Japan could generate returns like those from Emerging Markets between 2003-07. That is roughly what they thought about EM before it happened.

So if there is a dip in global equities, we would use the opportunity to buy Eurozone equities, as the short-term trade. If the correction looks like the precursor to a more significant downturn, or if it doesn’t happen until after the Eurozone has closed the gap with the US, we would increase exposure to Japan. Our tactical models are trending in this direction, but this is a longer term call, which depends on the government finally delivering on its programme of improved corporate governance.

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